René Nourse, CFP®
Life insurance. It’s tough enough figuring out how much you need, but it can prove to be even more daunting to determine what type of insurance to buy. Before we delve into the different types, let’s briefly visit why you need life insurance in the first place.
The primary reason you need life insurance is to provide financial support for anyone who is and will be dependent on you for their livelihood. Typically that means family members—immediate or extended—and/or business partners. Unless you are very well off and have a great deal of liquidity, life insurance is the easiest and most cost effective way to protect your dependents and business interests.
So now that you know why, let’s look at what kind of life insurance to get. There are basically four types of life insurance products: Term, Whole, Universal and Variable Life. There may be some other variations of these, but for the most part, these are the ones.
This is typically the least expensive form of life insurance to own. As the name implies, this type of insurance covers you for a specific “term” or time period. The terms can range anywhere from one year to as long as 30 years. During the specified term, the premium that you pay remains the same. Upon the end of the term, your costs will increase. Why? Because you are that many years older. So over time renewal costs could become prohibitive. Also, there is no cash build up in the value of the policy. It’s a little bit like renting property vs. owning.
Whole life has a cash savings component, and the premiums and coverage remain level for your entire life—hence the name “Whole Life”. The premiums for whole life insurance are higher than for term life, since a portion goes towards paying for the insurance and the other portion goes towards savings. As the cash value of the policy grows, you could even exercise an option to borrow against the policy on a tax-free basis.
Universal life is a highly flexible life insurance agreement that allows the owner to change the premiums as well as the death benefit. Premiums can be increased, decreased, or even deferred—which, of course, will affect the ultimate death benefit. Because there is a cash value component, funds can be withdrawn from the or borrowed against. These types of policies generally offer a guaranteed return on the cash account, which is generally higher than whole life policies.
Variable life insurance agreements combine a fixed death benefit with a broad selection of investment options. For both Universal and Whole Life policies, the cash value grows at a fixed rate. However, Variable Life contracts allow you to place the funds in a wide array of mutual fund sub-accounts. In this manner, policy holders can potentially earn more than fixed rate contracts can offer. However—and this is really important to understand—as the name implies, both the cash value of the policy and the death benefit will fluctuate in value based on the performance of the investments. On the plus side, if the funds are managed properly, you can potentially avoid taxes on any gains and/or dividends.
Choosing the right type of life insurance policy is an important decision, since this is a contract that you will likely keep for a long time. The last thing you want is for the policy to lapse without a replacement. Keep in mind that the older you are, the higher the costs will be. And, of course, should there be changes in your health, you might become uninsurable or be subject to higher premiums.
A financial advisor can assist you in selecting the right type of insurance since your current and future cash flow needs—as well as an your health outlook—will help determine what type of contract is the best fit.